As a follow-up to last month's podcast on the agency mortgage market, we wanted to check in this week on the state of the overall U.S. housing market. The recent housing data has definitely been weak, but is this just a slowdown after years of robust activity or something more ominous?

After several years of strong growth and price appreciation following the financial crisis, the housing market saw a slow and steady decline in 2018. By the end of the year, the data turned decidedly worse, leading to concerns that the housing market was approaching the end of the cycle. December was a month to forget for the housing market with existing home sales and housings starts falling by 6.4% and 11.2%, respectively, and the National Association of Home Builders Index falling to the lowest level since 2015. Also in the fourth quarter, the residential investment component of GDP, a good proxy for home construction, was down 3.5%, the fourth straight quarterly decline. Home prices finished the year with a very respectable 4.7% gain, but the annualized rate of increase has steadily softened from the peak of 6.25% at the end of 2017. Particularly worrisome was the reversal of leaders in the housing recovery like San Francisco and Seattle, which saw their three-month annualized home price appreciation turn negative at the year-end.

Several factors turned into headwinds for the housing market in 2018. First, the housing market remains one of the most interest rate sensitive economic sectors and demand softened in the face of four Federal Reserve rates hikes and mortgage rates climbing by 100 basis points. The good news for the housing market is that mortgage rates have declined 50 bps since the November peak and the Federal Reserve has signaled a pause in the rate hike cycle. Next, home affordability has also declined, primarily due to the rise in mortgage rates and cumulative increase in home prices since the housing collapse. Since the trough in 2012, home prices on a national level have increased over fifty percent. While home affordability has fallen, it remains attractive on an historical basis and the decline in mortgage rates should help stabilize the market. One last headwind to mention is the 2017 tax cuts, which limited deductions for mortgage interest and state and local taxes. It remains to be seen the long-term impact of the tax law change, but all else equal, it should make housing less attractive to individuals in high tax states like California and New York and for purchases of expensive homes.

In addition to the recent decline in mortgage rates, there are some reasons for optimism. The strong labor markets and wage gains continue to be important tailwinds for the housing market. There are also signs of improving demographics with an upturn in both the homeownership rate and household formation. The homeownership rate increased to 64.8%, the highest since 2014. The ownership rate was helped by an uptick in demand from millennials, who have long delayed home buying as they establish their careers and pay off student loan debt. Another positive is an improved outlook from homebuilders. Broadly speaking, homebuilders see trends improving in 2019 with lower interest rates, dovish Federal Reserve commentary, and the rebound in the stock market. They commented that while higher mortgage rates hurt affordability, the steep equity market selloff also impacted homebuyer confidence.

When we put all the pieces together, we see the housing market slowing, but not falling into the abyss. We would expect price gains to moderate towards wage growth, around 3%, and home sales to stabilize. The strong labor markets, improving demographics and the recent decline in mortgage rates should benefit the market as we enter the important spring selling season.

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